Update and Outlook: The Winds of Change
Like the weather, investors can face a number of environments when making investment decisions. The best environment is a combination of strong economic growth, high employment, rising wages, corporate earnings and dividends. Many of these metrics began to show signs of life at the end of 2016 after very mediocre growth and various setbacks over the past decade.
The Eurozone is growing particularly fast, thanks to a still undervalued currency, rising confidence and considerable pent-up demand, while other developed markets like Japan, Canada and the U.S. continue to accelerate. The UK appears to be weathering the impact of the Brexit vote better than many had feared, thanks to more competitive exports on a weaker currency. Meanwhile, a rebound in demand for commodities continues to be a positive for Latin America, Canada and Australia, while the Chinese contribution has ebbed slightly in recent months as authorities try to restrain financial speculation. All-in-all, the global economy is growing everywhere but booming nowhere - something that adds a degree of stability to future growth.
Over the past decade, the goal of the central banks was to normalize inflation through the use of quantitative easing (QE) - they have succeeded. While interest rates remain low by historical averages, there is sufficient growth pressure for yields to head up over the coming years. We have some concerns that many of today’s investors have not been exposed to a rising interest rate environment, or have just forgotten,and thus may not appreciate the additional market volatility that accompanies it.
In the later stages of economic growth, stocks tend to perform well until monetary policy becomes too tight - which is some ways off. Nevertheless, this change in environment will take some time to price in and thus we are expecting higher levels of market volatility than we have experienced over the past few years. Fixed income markets will likely have some headwinds to deal with. A broadly diversified and global approach to equities should serve portfolios well. With their improving growth prospects and strengthening currencies exposure to emerging markets is now warranted for many portfolios. Diversifying into alternative sectors, such as private debt, has the potential to provide a return premium over bonds which should compensate for the weaker estimated returns for fixed income.
Beginning in 2017, politics began to dominate market psychology which unfortunately is unpredictable. Canada has yet to have firm answers on NAFTA and in fact the trade negotiations have been shunted into the background. The Mexican elections this summer are likely to see a strongly anti-American left-leaning candidate elected.
NAFTA could face significant challenges. In this environment we see Canada’s economy continuing under pressure. Corporations will be hesitant in making expansion decisions that contribute to economic growth. Foreign investors are more likely to exit Canada than to invest. The ongoing opposition from BC to the Kinder Morgan expansion of the Trans Mountain oil pipeline is particularly concerning. Without access to international markets Alberta’s oil industry cannot grow. This kind of activity reflects poorly on Canada’s reputation as a country to invest in.
Our hot housing market, which has been a significant contributor to Canada’s growth, is now showing signs of a correction as tougher mortgage lending terms combined with interest rate increases to over leveraged consumers come into effect. Canadian home sales fell 23% from a year earlier levels. Average house prices are down 10.4%. Buyers have turned to condos, but statistics show present condo prices leave many investors who buy to rent with negative cash flows. Whether the rental market for condos can sustain the rent increases needed to provide positive cash flows is uncertain. Improving commodity markets plus a lower Canadian dollar will have a positive impact on growth, but annual GDP growth will likely come in below 2% - well behind the U.S.
Lastly, it should be noted that many asset prices are higher than they were a year ago. Because of these higher valuations and potential dangers from policy mistakes or geopolitical risks, it will be even more important for investors to maintain well-diversified portfolios, which include both broad based equity portfolios with moderate exposure to emerging markets, combined with alternative assets classes such as real estate, private debt and hedged credit strategies.